What's Next in Store for the Australian Dollar

The Australian dollar has been caught in a tight trading range ($1.02-$1.06) for the past nine months, and appears to be going nowhere fast! The buying forces of offshore money — from both global investors in search of yield and speculators riding the momentum and "carry" trades — have been neatly balanced by the selling forces of Australia's weakening terms of trade*, falling commodity prices being the chief culprit. Of course, the biggest risk for Australia's economy and demand for its currency is China, it's primary trading partner — and China's economy is slowing! Our analysis below tries to cover the relevant factors in determining what's next in store for the Aussie.

Fundamental Analysis

The two tables below show performances of the major global currencies against the US dollar over the last three months (left table) and since early 2009 (right table), which was the bottom of the global financial market meltdown.

Over the last three months, the Australian dollar along with its neighbor the New Zealand dollar were at the top of the performance chart. Although the performance results were small to be sure, they were facing the headwinds of a strong dollar trend. Looking at the chart on the right, since March 2009 when all foreign currencies had finished their dramatic and significant fall against the dollar, the AUD and NZD were again star performers.

3 MONTHSSPOT RETURNS

MARCH 2009- APRIL 20l3SPOT RETURNS

Source: Bloomberg

There are multiple themes currently driving the value of the Australian dollar. I have listed five in what I consider the order of impact:

“Risk on” : For now at least, forget about the fact that global economies are decelerating. Focus on central banks - the Fed, Bank of England, ECB, and most recently the Bank of Japan – all are flooding the market with massive amounts of liquidity, which in turn is fueling rallies in equity markets around the world and the foreign currencies needed to purchase those equities. Good for the Australian stock market (YTD +12%) and the AUD.

The “carry trade” still lives: Defined as a strategy of borrowing a currency with a relatively low interest rate and using the funds to purchase/invest in a different currency with a relatively higher interest rate, and earning the difference. The AUD:JPY trade has been one of the most popular and profitable carry trades for several years. Short-term Australian money market rates near 3% and Japan’s rates at 0.20% still make for an attractive carry trade of about 2.80% on an annualized basis. Good for AUD.

Commodity prices mixed: Australia’s economy is highly dependent on its natural resources. Prices of six of their top exporting commodities showed mixed performances in 2012: Lower commodity prices are not good for Australia nor the AUD

COAL – Australia is the world’s 4th largest producer. Prices dropped by 11% in 2012.

IRON ORE – Australia is the world’s 2nd largest producer. Prices dropped by 12% in 2012.

BAUXITE – Australia is the world’s 1st largest producer. Prices rose by 10% in 2012.

COPPER – Australia is the world’s 5th largest producer. Prices dropped by 15% in 2012.

ALUMINUM - Australia is the world’s 2nd largest producer. Prices rose by 2% in 2012.

WHEAT – Australia is the world’s 4th largest producer. Prices rose by 19% in 2012.

This chart shows the widening divergence between the Australian dollar (gold line) and the Commodity Research Bureau (CRB) index (black line). Clearly the AUD has been gaining ground recently despite a decline in commodity prices. In a country so heavily dependent on commodities, such divergence typically does not last long. Since I truly doubt that commodity prices will bounce from here, I am inclined to believe that the AUD will decline in value…eventually.

Source: Bloomberg

China's economic growth: Australia has unprecedented reliance on China as a target export market, accounting for nearly 30% of all Australian exports. Interestingly, Australia is the fifth biggest source of Chinese imports, so we should not be surprised to learn that China and Australia recently said they are setting up an agreement to make the AUD freely convertible to Chinese yuan (without US dollar intermediation). It would make the AUD just the third currency - after the dollar and the yen - to achieve this status, a net positive for Australian businesses and the reputation of the country's currency alike. Good for AUD.

Reserve currency status: Historically, the world's safest currencies were considered to be the USD, EUR, GBP, JPY and Swiss franc. However, recent economic problems associated with the countries of those currencies (except for the Swiss) has led to increased need/demand for safe-haven alternatives and for diversification, meaning more reserve currencies. As a result, the IMF last November announced plans to add the Australian dollar and the Canadian dollar to its list of official reserve currencies. Good for AUD.

Technical Analysis

Most of us manage our currency exposures within a one year time horizon. I present below charts of the price action of the AUD:USD that will help us forecast where we think theAustralian dollar may go over the coming months/year.

We can see that the AUD:USD over the past three years has been caught in a symmetrical triangle pattern. These types of patterns are typically seen as continuation patterns in classical technical analysis, but I see no reason why it can't end up being a reversal pattern, meaning that it could break out of the triangle to the downside.

Source: Bloomberg

Looking at a chart going back to 1971, you can see that AUD:USD is currently trading in a long-term "retracement box" (in red), defined as a retracement from the highs reached in 1974 to the lows seen in 2001. Classic technical analysis contends that retracement levels of 50% and 62% are the most important, and the range between the two rates that correspond to those percentages serve as: 1) a target objective for the retracement itself, and 2) key resistance against the uptrend. The box's range is $0.98-$1.10. The AUD did poke its nose briefly above $1.10 in July 2011 and then was quickly rejected from there, dropping 12 cents in the next two weeks!

Source: Bloomberg

My interpretation of the two charts: the AUD uptrend is still intact, the trend has not reversed itself...not yet anyway. However, the odds for the AUD to continue higher have dropped considerably, approaching 50:50, as it has met with strong resistance in the form of (1) previous highs near $1.06, (2) the descending top of the triangle pattern near $1.05, and (3) the long-term "retracement box."

Sentiment Analysis

For additional help in forecasting currency trends, I use the CFTC's Commitment of Traders (COT) Report, which provides weekly data on currency futures and options trading activity/positions. It breaks up the data into three market segments, activity of (1) large speculators, (2) small speculators, and (3) commercial hedgers. In each report I look for (a) extreme positions, (b) changes in market positions, and/or (c) changes in open interest.

The most recent COT report shows that extreme long AUD positions held by large speculators have been reduced substantially over the last two months. Small speculators have actually gone a tiny bit short the AUD! Commercial hedgers, historically considered the "smart money" players, have been running short positions in the Australian dollar for most of the last 12 months, but interestingly, have reduced their short positions over the last two months. I would consider this a fairly neutral report on the AUD.

Conclusion

The Australian dollar remains a strong currency; however, there are several negative fundamental factors gaining ground. Over the upcoming weeks/months, I will be watching very closely (1) the AUD:USD charts, (2) China's economy, (3) the US stock market, as a way to monitor the market's risk appetite and their expectations of Fed action, and (4) commodity prices. I will keep you abreast of significant moves one way or another.

Currency Management Action Plan

First, a few things to consider when developing a currency management strategy for the Australian dollar: (1) treat currency risk as a business risk, to be managed like other business risks (2) movements in the Australian dollar may/may not have a significant impact on your firm's performance, (3) take into account the probabilities assigned to the movements of the currency.

Yes, I believe the odds suggest that you should build a neutral Australian dollar into your currency management strategy. US exporters into Australia may wish to consider (1) pricing more product or service in US dollars, (2) doing a bit more hedging of AUD-denominated revenues, and/or (3) leading, not lagging, conversions of AUD receivables into US dollars. US importers from Australia or those with payables denominated in AUD may wish to consider (1) keeping more input/costs in AUD, (2) doing somewhat less hedging of AUD payables, and/or (3) lagging conversions of US dollars into AUD.

*Defined as the ratio of the price of a country's exports over the price of its imports

The Australian dollar has been caught in a tight trading range ($1.02-$1.06) for the past nine months, and appears to be going nowhere fast! The buying forces of offshore money — from both global investors in search of yield and speculators riding the momentum and "carry" trades — have been neatly balanced by the selling forces of Australia's weakening terms of trade*, falling commodity prices being the chief culprit. Of course, the biggest risk for Australia's economy and demand for its currency is China, it's primary trading partner — and China's economy is slowing! Our analysis below tries to cover the relevant factors in determining what's next in store for the Aussie.

This is my market analysis on the Australian dollar using three different types of analysis: fundamental, technical and sentiment. As I've mentioned before, this multi-dimensional analysis has worked well over the years. For an explanation of how and why it works, go to http://www.svb.com/Blogs/Scott_Petruska/Analyzing_the_Currency_Markets__Improving_the_Odds_of_Success/ .